A credit derivative is a derivative whose price and value derives from the creditworthiness of the obligations of a third party, which is isolated and traded." Credit default products are the most commonly traded credit derivative product and include unfunded products such as credit default swaps and funded products such as synthetic collateralized debt obligations (synthetic CDOs).
Credit derivatives, in their simplest form, are bilateral contracts between a buyer and seller under which the seller sells protection against certain pre-agreed events occurring in relation to a third party (usually a corporate or sovereign) known as a reference entity. These events are called credit events and they relate to the creditworthiness of the reference entity. The reference entity will not (except in certain very limited circumstances) be a party to the credit derivatives contract, and will usually be unaware of the contract’s existence.
The parties will select which credit events apply to a transaction and these usually consist of one or more of the following: bankruptcy (the risk that the reference entity will become bankrupt); failure to pay (the risk that the reference entity will default on one of its obligations (e.g. a bond or loan); obligation default (the risk that the reference entity will default on any of its obligations); obligation acceleration (the risk that an obligation of the reference entity will be accelerated e.g. a bond will be declared immediately due and payable following a default); repudiation/moratorium (the risk that the reference entity or a government will declare a moratorium over the reference entity’s obligations); and restructuring (the risk that obligations of the reference entity will be restructured).
If the credit derivative is entered into by a financial institution or a special purpose vehicle and payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations.
